Tuesday, August 21, 2012

College Savings Plans: A Better Alternative?

With the rising costs of university and college tuition what does a parent do? I have helped thousands of people put away money for one purpose or another for over thirty years and I am often asked about College Savings Plans, also known as 529 plans after the IRS code section that allows them. Parents and grandparents want to know if investing in them is a good idea.

529 Plans
A 529 plan is basically a way to save money for college with tax-free growth, as long as those funds are used for qualified educational expenses. This sounds good, but there are three distinct reasons why you may want to avoid them.

First, most of these programs aren't savings accounts at all; they are mutual funds that are invested in the stock market with all the risks that investing in the market entails. As I write this, looking at the five-year rates of return, both the Dow Jones Industrial Average and the Standard & Poor's Index were negative over this time period. So, a family that sets up this account because of the tax advantages for college may find that none exist, or worse, they have actually lost money in this account when it is time to pay for school.

Second, most parents need to focus on college planning long before their children are in high school. The major advantage to a 529 plan is that if there is considerable compound interest in the plan, it can be withdrawn tax free. But, if a family is funding the plan when the student is older, it doesn't really have time to grow.

The Real Reason to Consider Other Options
The real reason that a 529 savings plan isn't usually a good option for many families, though, is because it can actually prevent them from receiving need-based financial aid if they would have been otherwise eligible for it. Yet I have seen many families that make very good incomes qualify for need-based financial aid if they understand the system. Let me explain.

According to the Department of Education, at a public school, 529 savings plans are counted against a parent at 5.40% annually. In other words, a family that saved $100,000 in this account would be expected to pay $5,400 more than a family that didn't. That's not so bad, but it can actually get worse. Some private colleges and universities will actually take up to $20,000 (20% of the $100,000) and set that aside for education purposes. Under these circumstances, that family would lose $80,000 in need-based financial aid (if they would otherwise been eligible for it) because nobody bothered to explain to them how a 529 savings plan is counted in the financial aid formula.

Obviously, every situation is different, and there are plenty of cases where using one of these vehicles makes some sense. However, we have found that we can accomplish some of the same things that a 529 savings plan can with dividend paying whole life insurance.

Advantages of Using Whole Life Insurance
The advantages of using whole life insurance are numerous. First, the policy pays a guaranteed interest rate that is not subject to the ups and downs of the stock market. Second, if constructed and used correctly, the money in the account can be used tax-advantaged, just like a 529 plan. Third, insurance is specifically excluded from being counted as an asset in the federal formula that the Department of Education uses to determine what a family can pay for college. This, in turn, could make a student eligible for grants and scholarships. So, when thinking about saving for college, be sure to consider whole life insurance as an alternative to a 529 savings plan.